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There is much new lingo in the investing world as of late, such as LIBOR, the Baltic Dry Index, and “carry trades”. The carry trade is getting some serious play in the media so I thought I would give a very basic explanation of what it is, and why it may be playing a very large role in the “global de-leveraging” (another new buzz phrase) that we are experiencing now.
The Yen Carry Trade
A carry trade is, at the very elementary level, shorting a currency in which the native country has low interest rates and using the proceeds to purchase currency in a country that has higher interest rates. So long as there are no changes in the exchange rate, your rate of return is very close to the differential in interest rates. Example: If you sell 100 Japanese Yen and pay interest of 0.5% in Japan, you could take that 100 Yen and convert it to $1 Canadian Dollar (not the actual exchange rate, just an example). You can take that $1 Canadian Dollar and buy a Canadian Government Bond that pays 3%. Your rate of return is 3% less 0.5% which equals 2.5%.
Levering Up The Carry Trade
Here’s where the leverage comes into play. Forex and CFD brokers can allow for hideous amounts of leverage – I’ve seen factors as high as 200:1. If we take a *cough, cough* “conservative” leverage factor of 10, essentially you can earn 25% on the above carry trade example on your original principal.
Supply and Demand
Here’s another factor. The Yen Carry Trade is well practiced, there are trillions of dollars wound up in it, and all the shorting pressure on the Yen served to depress the Yen – which was even better for carry traders since when they received their interest and principal repayments from the other currencies and then converted them back to Yen to pay off their short positions, they made money on the conversion since the Yen had weakened. The money being made on the Yen Carry Trade was hideous.
A Paradox
Normally, if someone were to try and execute a carry trade, the theory of uncovered interest rate parity would dictate that the differential in interest rates signalled the direction in change of the currencies – such that no money should be made by executing a carry trade – kind of like a self-correcting arbitrage mechanism. However, the tremendous short positions required to initiate the Yen carry trade worked to throw this in reverse, keeping the Yen depressed and further fuelling the fire.
De-Leveraging
The Yen has been exceptionally strong as of late and this may have caused a massive unwinding of the Yen Carry Trade all at once. This entails de-leveraging and short covering which further exacerbates the rapidity of the unwinding, since short covering drives up the Yen. It has been estimated that there is over three times as much money tied up in the Yen Carry Trade as there is value in all the known oil reserves in the world. Now that is truly scary. The rise in the value of the Yen is near the top of the list of concerns for the G-7 nations who only this week issued a statement singling out the Japanese currency and it’s role in the current global economic crisis.
It’s nice how you take information that normally I would just gloss over in the paper and make it so digestible. I’m beginning to really take a deeper interest in the business section. Ever thought about doing a column?
Great article. I’ve never understood the concept of “Carry Trade” so appreciate your clear explanation!
Preet – could you explain further what the implications of the carry-trade deleveraging means to the broad market, esp our north american markets? Is it mostly a currency concern? Thanks.
@Deb – Excellent question and I will write a follow up tonight – there are more implications than just currency… I haven’t forgotten about your questions on inflation, deflation and stagflation, etc. It’s on the to-do list! :)
I’m so glad to find an article discussing the true issue causing the dramatic moves in this stock market and if this is not corrected we run the risk of further financial collapse. The danger of the Yen Carry Trade is made worse by the global leaders that are unaware of the direct relation with it’s responsiblity to the stock market’s instability. Thus, these leaders are making it worse by cutting each countries interest rates which devalues their currency against the Yen and puts additional pressure to unwind this trade. Look at a chart of the EuroJPY versus the Dow or any etf including gold and oil and you will notice an almost minute by minute inverse relationship. This issue is serious. Although this might sound crazy do you think there is any way to get a message to our new or current President? It would shock the world if Obama publically mentioned that he planned to put pressure on Japan to lower the value of the Yen and intended to discuss this with the G7 in addition to discussing world wide limits on currency trades. These leveraged limits are critical now that the world can trade our markets at the push of a button with the invention of the Internet and the ETFs in 1999 and more importantly their astronomical growth in only the past 5 years. Apologies for the lengthy comment.
p.s. a print button would be helpful if you can do it on your page. ;)